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Want to make the merger gods laugh? Tell them your turnaround plans in a low interest rate environment.

Hudson City Bancorp (HCBK) could no longer defy the odds of interest rate risk, agreeing Monday to sell itself to M&T Bank (MTB) for $3.7 billion. The deal, one of the largest in years, is a hard-luck ending for a former industry darling that relied too heavily on making jumbo home loans financed by wholesale funds.

The $44 billion-asset Hudson City's inability to find a new way to make money in the face of depressed interest rates and weak housing demand foreshadows the choice that scores of banks may confront, experts say. A lot of banks that primarily made home loans before the crisis seek to branch into wealth management, business banking or other niches. Hudson City tried — and ultimately failed — to wean itself off securities and wholesale funds.

"For companies like Hudson City that need to transform their business model, this represents a recognition that it is difficult to do that in this economic environment," says Ben Plotkin, a Stifel Nicolaus investment banker who handles bank mergers and is not involved in this deal.

On the flip side, Wall Street may be warming to big takeovers, the deal shows. The 4.5% increase in M&T's share price as of late Monday shows that investors may be snapping their habit of punishing acquirers when they announce big deals — so long as they are cheap and sensible. This agreement appears to be both. The $80.8 billion-asset M&T would pay just 80% of tangible book for the 135-branch Hudson City, which needs to diversify because more than 90% of its assets are tied to home loans.

"What it says is that potential acquirers who have protected the value of their currency have the ability to do transactions when they find the right opportunity," Plotkin says.

M&T — good at buying good banks that fall on hard times — wants to get bigger in New Jersey, Robert Wilmers, the company's chief executive, said in conference call with investors and analysts Monday.

"While M&T has no full-service branches in New Jersey, we've long had a presence across the river" in New York City, he said.

The 735-branch M&T also has a need for the $26 billion in mortgages it is to acquire in the deal because its seeks some fixed-rate assets, executives said. M&T is in a so-called "asset-sensitive" position. That means its mixture of assets and liabilities is calibrated in a way that will boost profits when interest rates rise. Hudson City — having braced itself for an extended period of low-rates- is inversely positioned. It stands to be hurt when rates rise.

"This allows us to absorb the interest rate risk inherent in Hudson City's balance sheet," Rene Jones, M&T's chief financial officer, said during the call. "It's one of the very nice benefits of the transaction that make a lot of sense," he said later.

M&T expects the deal — scheduled to be completed in the second quarter — to immediately add to profits and to boost its core capital levels, which are currently slightly below peer levels.

Hudson City of Paramus, N.J. — lauded as one of banking's best performers just two years ago — is selling because its business model of using wholesale borrowings to fund mortgages on big expensive homes has been crippled by low interest rates and the housing crisis. Those pressures have acted as a vice on the $44 billion-asset company's margins while stymieing its turnaround efforts in the last 18 months.

Regulators more than a year ago began pressuring Hudson City — which also depends on income from mortgage-backed securities to bolster profits — to overhaul its balance sheet so that it could cope with an inevitable rise in interest rates. The company sought to unload securities and wean itself off Federal Home Loan Bank of New York advances. The thrift — in a major strategy shift — also said in July that it would begin selling to investors mortgages it originates rather than hold them as investments.

But two important events interfered with Hudson City's turnaround plans: the bumpy economy and the health problems of Chief Executive Ronald Hermance Jr. He took a medical leave in February after a physical revealed he had an unusually low blood-cell count; he returned to work this month.

Hermance would join M&T's board once the deal is completed.

Hudson City's return on average assets — the basic gauge of profitability — was 0.66% at midyear, up from negative 1.65% a year earlier. It earned $172 million in the first half of 2012, after losing $736 million in full-year 2011 and earning $537 million in full-year 2010.

Its decision to sell is the best move for Hudson City customers and investors, Hermance said during the call. The company faced an uphill struggle requiring big investments of capital, time, and people, he said. Hudson City did not seek buyers but was approached by M&T, he said.

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Comments (2)

In my lifetime I never thought I would see money being worth nothing and with long rates where they are, it should be that way for some time. With the arbitrage opportunity for excess funds gone, banks will have to look at other asset categories, other fee income plays or a merger with someone where duplication of over head expenses are significant.

Posted by T Stephen Johnson | Monday, August 27 2012 at 6:03PM ET

Matthew: This exposes the basic flaw in the "originate and hold" mortgage business model. The FHLB advances used to fund the mortgages carry a steep prepayment penalty, yet the 30 year mortgages originated have no prepayment penalty. In a declining interest rate environment, borrowers refinance at lower rates, leaving the banks with significant margin compression. The answer to properly match fund and appropriately hedge interest rate risk without engaging in dangerous derivatives is simple: originate the mortgages with prepayment penalties. Unfortunately, the market will not allow that. The result? Community banks are pushed out of the mortgage business, or forced to sell to the GSE's or the megabanks, perpetuating TBTF. They become necessary by design.

Posted by Robert A. Catanzaro | Sunday, September 02 2012 at 11:00AM ET